Qualified Opportunity Zone Funds Explained
Qualified Opportunity Zone Funds have gained significant interest from tax paying investors. But what exactly are these funds and who do they benefit?
What exactly are qualified opportunity funds?
Legislation enacted in 2018 provides taxpaying investors with compelling tax advantages if they invest their capital gains in Qualified Opportunity Zones (QOZs).
This law was set up to encourage private investment in distressed communities throughout the United States. The U.S. Treasury has certified a number (8,762) of low-income, disadvantaged communities as QOZs.
Qualified Opportunity Funds (QOFs) are vehicles that invest in qualified opportunity property where property is defined as QOZ stock, partnership interests, or business property. These funds must hold at least 90% of their assets in QOZ property (real estate or businesses).
Investors can defer taxes on almost all capital gains that they have made on any type of investment by investing those capital gains in these QOFs, subject to certain regulations.
Additionally, depending on the duration of the holding period of that QOF investment, they can also benefit from a reduction in their total tax liability. Lastly, investors do not have to pay capital gains tax on any profits earned by QOFs if held for a ten-year period. The program runs up until 2026, as such investors need to invest their capital gains before year-end 2019 in order to qualify for the maximum tax reduction of 15% after a seven-year hold period.
As of September 23rd, the Opportunity Zones Database listed 117 QOFs with a total investment capacity of $37.4 billion and target fund sizes ranging from a low of $50m to a high of $5B. This number is expected to grow as other fund managers launch new products.
While early fund launches tended to be smaller in size, in the last few months a number of large-scale institutional quality managers have entered the arena with funds typically targeting in excess of $500m.
Many of these opportunity zones have already started to experience a pickup in investment activity. Real Capital Analytics estimates that these zones collectively have attracted about $50 billion in annual acquisition volume in recent years and approximately $34 billion of commercial construction starts.
Possible Advantages of Opportunity Zone Investing
Opportunity zone investments offer several potential benefits for investors. First, they feature favorable tax benefits, allowing investors to defer (up until 2026), reduce (by up to 15%) or eliminate (on QOF profits if held for ten years) capital gains taxes.
In addition to tax benefits, a growing number of high caliber, institutional quality fund managers are now offering QOFs. Many of these managers have prior experience investing in these qualified zones, making their strategies more appealing.
QOFs also offer significant diversification benefits, as investors would have limited exposure to these disadvantaged, low-income areas previously. These funds can invest in a wide spectrum of investment opportunities including real estate (both commercial and non-commercial), infrastructure and existing or start-up businesses.
These zones can offer investors exposure to non-core property types such as affordable housing, medical office, single and multifamily rental, senior housing, student housing, warehouses and data centers.
They also have the potential to earn compelling positive returns, the capital gains of which is tax free (if held for ten years), with the large majority of these zones offering investment managers the potential for acquiring assets at discounted pricing.
Opportunity zone investing has an ESG/impact benefit as well, though mostly for the “S” or social piece of ESG. The opportunity zone program has the potential to catalyze billions of dollars of investment in these economically disadvantaged zones by targeting the trillions of dollars in unrealized capital gains across the country.
The U.S. Treasury estimates that there is approximately $6 trillion in unrealized capital gains held by U.S. households and businesses. As such, even a small percentage of this could have a significant positive impact on an opportunity zone.
Issues to Consider Before Investing
While there are advantages to QOF investing, there are also a few aspects investors should consider.
There is the issue of investment performance risk – and not just due to manager-related issues. If investments do not produce the occupancy rates or revenue targeted – for whatever reason – then gains will not be generated in an amount at least equal to the re-invested initial capital gains in these projects.
Said another way, there is a risk that the QOF could end up converting capital gains in hand to losses if the OZ assets do not produce.
Also in terms of performance risk, the popularity of this sector could work against it if increased investor interest and competition for deals in these zones drive up asset pricing.
Further, while a number of GPs have previously invested in these disadvantaged zones, some managers in this space will be less experienced.
This investment opportunity is somewhat time-sensitive. To qualify for the maximum tax reduction (15% tax reduction if held for 7 years) investments in QOFs must be made by December 2019.
In addition, these are long-term investments of 10 years (to allow investors avoid the capital gains taxes on the profits of the OZF investment). As such, these funds may be negatively impacted by any changes in federal law that might reduce their tax benefits over time.
While this investment may be considered an impact investment, again, the impact here is mostly in the social area, not in environmental or corporate governance considerations, so managers are currently under no obligation to report on the success of these investments or to coordinate with community leaders.
There is some concern that increased investment in these zones may result in higher pricing, which could ultimately price out the very people that this program is intended to help.
Additionally, many of the designated opportunity zones, particularly those in major cities such as New York, are already attracting a significant amount of investment capital and under the new regulations should continue to do so, or in fact, receive more than their fair share of it, while other more disadvantaged rural communities may be ignored.
This is not that surprising as initial investments will favor the most attractive locations, however, it is very early days and the program still has a number of years left to run. Additionally, new reporting requirements that are likely to come into effect will require fund managers to measure the social impact of their investment efforts.
Qualified opportunity funds can offer compelling potential, particularly for taxable investors. However, this relatively new type of investment comes with a few risks and a swiftly closing window for investment.
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